Hamilton: "Understanding Crude Oil Prices"

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Here I wanted a light weekend and what does Jim Hamilton do but go and put up a link to a very interesting new paper of his. This is from the introduction:

How would one go about explaining what oil prices have been doing and predicting where they might be headed next? This paper explores three broad ways one might approach this. The first is a statistical investigation of the basic correlations in the historical data. The second is to look at the predictions of economic theory as to how oil prices should behave over time. The third is to examine in detail the fundamental determinants and prospects for demand and supply. Reconciling the conclusions drawn from these different perspectives is an interesting intellectual challenge, and necessary if we are to claim to understand what is going on.

In terms of statistical regularities, the paper notes that changes in the real price of oil have historically tended to be (1) permanent, (2) difficult to predict, and (3) governed by very different regimes at different points in time.

From the perspective of economic theory, we review three separate restrictions on the time path of crude oil prices that should all hold in equilibrium. The first of these arises from storage arbitrage, the second from financial futures contracts, and the third from the fact that oil is a depletable resource. We also discuss whether commodity futures speculation by investors with no direct role in the supply or demand for oil itself could be regarded as a separate force influencing oil prices.

In terms of the determinants of demand, we note that the price elasticity of demand is challenging to measure but appears to be quite low and to have decreased in the most recent data. Income elasticity is easier to estimate, and is near unity for countries in an early stage of development but substantially less than one in recent U.S. data. On the supply side, we note problems with interpreting OPEC as a traditional cartel and with cataloging intermediate-term supply prospects despite the very long development lead times in the industry. We also relate the challenge of depletion to the past and possible future geographic distribution of production.

Our overall conclusion is that the low price-elasticity of short-run demand and supply, the vulnerability of supplies to disruptions, and the peak in U.S. oil production account for the broad behavior of oil prices over 1970-1997. Although the traditional economic theory of exhaustible resources does not fit in an obvious way into this historical account, the profound change in demand coming from the newly industrialized countries and recognition of the finiteness of this resource offers a plausible explanation for more recent developments. In other words, the scarcity rent may have been negligible for previous generations but is now becoming significant.

Some interesting extracts:

All of the above test results are consistent with the claim that the real price of oil seems to follow a random walk without drift. The price increased over the sample by 172% (logarithmically), but a process like this one could just as easily have decreased by a comparable amount. While one might have forecasting success with more detailed specifications over shorter samples, the broad inference with which we come away is that the real price of oil is not easy to forecast….It is sometimes argued that if economists really understand something, they should be able to predict what will happen next. But oil prices are an interesting example (stock prices are another) of an economic variable which, if we really understand it, we should be completely unable to predict.

Hamilton goes through the economics of depletion, point out that it may be rational for producers to pump less under circumstances, and provides some anecdotal support, including this item from the November 2006 Energy Information Administration Country Analysis Brief on Kuwait

“Project Kuwait,” to be developed over 25 years, was first formulated in 1997 by the SPC, to increase the country’s oil production by 500,000 (and to help compensate for declines at the mature Burgan field)…. However, the controversy over Kuwait’s reserve figure could have a significant impact on the country’s capacity expansion plans. Opposition MPs have called for production to be kept within 1 percent of reserves in order to ensure that oil is available for future generations, though the proposal has not yet been passed into law. Even taking the 100-billion-barrel figure, the 1 percent limit would restrict Kuwait’s production to under 3 million bbl/d, increasing difficulty of efforts to pass the Project Kuwait legislation.

For the cautious Hamilton, this bit was a surprise:

At any given point in history, some of the world’s producing fields are well into decline, some are at plateau production, and others are on the way up. It is not clear what “average” or “typical” decline rate would be appropriate to apply to aggregate global production, but a plausible ballpark number might be 4%. That means that in the absence of new projects, global production would decline by 3.4 mb/d each year. To put it another way, a new producing area equivalent to current annual production from Iran (OPEC’s second biggest producer) needs to be brought on line every year just to keep global production from falling.

Despite these discouraging observations, an update of the CERA methodology would leave one still quite optimistic about near-term oil supplies. An open-source web database6 tabulates a total of 6.9 mb/d in new gross production capacity from new projects that are scheduled to begin producing in 2008. Projects in Saudi Arabia, Russia, and Mexico account for about a third of this gross increase. Data currently available for the first two months of 2008 show actual production in Saudi Arabia down 350,000 b/d from its average 2005 value and Mexican production down 400,000 b/d from 2005. Russian production is down 100,000 b/d from its average level in the second half of 2007.

Although declining production from mature fields and delays in ramping the new fields up to full production will doubtless eat up a fair bit of the 6.9 mb/d new gross production capacity, it seems there is a lot left over. In the absence of significant new geopolitical disruptions to petroleum supply, some might anticipate an end to the recent plateau in global production, and significant net gains in supply for 2008.

Hamilton also stresses the limits of information. For instance:

In fact, the “quotas” and measured production levels are themselves fairly vague. The Energy Information Administration, International Energy Agency, and private organizations such as Platts all have different estimates of what the actual [OPEC] production numbers are.


The production declines [in Saudi Arabia} also coincided with a doubling in the number of their active oil rigs, leaving some to speculate that the magnificent Ghawar oil field had begun to decline. The necessary data to confirm or refute that conjecture are not publicly available.

The paper is very much worth reading, and also has quite a few good charts.

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  1. Anonymous


    I want to thank you for hosting, and others such as Moe Gamble and Juan for their frequent additions, to this conversation about oil prices.

    I have oil and gas investments, and am thinking about making more, and have found the discussion here on Naked Capitalism to be about as dispasionate and free of cant as any around, whether in the conventional media or the internet.

  2. Anonymous

    Hamilton’s getting closer to reality in this paper. I’m glad to see that he, unlike Hutchinson, gets the declining elasticity of demand right. However, there are still some problems (that aren’t all his fault). First, the open source web database (Wikipedia Megaprojects) about new projects coming online in 2008 has been out of date for months. Postponement after postponement has been announced, but they never change the database. I’d change it myself, but I don’t know how to do it.

    Hamilton gives a ballpark figure of 4% for the decline rate of existing production. I think that’s significantly too low. Schlumberger’s Gould puts the figure closer to 8% based on work with their clients. Total’s de Margerie put it at 6-7% over the past two years. Even CERA, which has a history of consistently overstating production, puts it at 4.5%. And none of these estimates take into account the extra energy being spent on production. In other words, the energy return on energy invested is dropping as well, because it is taking so many more rigs to get what production we’re getting.

    Also, the most important thing about the decline rate is that it is steadily increasing. That’s because newer projects, once they hit decline, tend to have a far sharper decline rate than the old-time projects did. Some of the old Permian Basin fields are still declining at only a very slow rate, while newer fields, such as the North Sea, have been subject to much better technology right from the start. When one of these newer projects goes into decline, production tends to fall off a cliff. Also, when a project is extremely expensive to produce, optimal return on investment is often obtained by going for the kill–producing as fast as possible, even if that means you end up leaving some oil behind that you might have gotten if you could have afforded to pump more slowly.

    I’d say there is no way at this point that we’re going to see 6.9 mb/d of new production coming online in 2008. We’ll be lucky to see 4 mb/d, and since at least half of that will come online in the second half of the year, we’ll see even less available in actual 2008 supply. In other words, the 2 mb/d that come online in the first half of 2008 will mean roughly 1.5 mb/d of actual 2008 supply, but the 2 mb/d that come on in the second half of 2008 will bring only 1 mb/d of actual 2008 supply overall, for something like 2.5 mb/d actually added to overall 2008 supply. If you add in some production that was just coming up to speed at the end of 2007, my own estimate is that we’ll see about 3 to 3.5 mb/d of new production in overall 2008 supply.

    All of this changes the supply picture enormously. We’re losing somewhere between 4 and 7.5 mb/d, give or take, and we’re adding only 3 to 3.5 mb/d.

    If worldwide demand were absolutely flat in 2008 (and it’s not–it’s still rising) and product prices tracked oil prices closely (they don’t, but they’re getting closer) this would mean prices would go up roughly 15% to 68%. A 1% rise in worldwide demand would raise prices another 15%. This means we could expect a price rise of roughly 30% to 80ish%, just to account for the decline rate and rising demand in China, India, and the oil-exporting countries.

    But wait, there’s more! Now you have to factor in the worldwide shortage of diesel, which is getting worse, not better (partly because of China’s earthquake emergency and natural gas shortages in the Middle East). And the diesel shortage isn’t easy to change quickly. It’s virtually impossible to get more diesel out of a barrel of oil than we’re currently getting, and changing away from diesel to a product that’s in less demand (like gasoline, or even solar power) is not fast or easy. It means changing how electric power is being produced and goods are being transported, and it means changing the existing car fleet. All of this will take time.

    I don’t agree that the real price of oil follows a random walk without drift, but that’s an argument between economists and traders that will probably never be resolved.

    I think it’s especially helpful that Hamilton points out how it may be rational for producers to pump less in some circumstances. I have posted this myself at nakedcapitalism, but I never provided a specific example, and Hamilton’s Kuwait example is a good one.

    Anonymous 9:05 am, I wish you good luck with your investments.

    Moe Gamble

  3. Anonymous

    ☺☺Moe Gamble said: “When one of these newer projects goes into decline, production tends to fall off a cliff.”

    There was an excellent write up on the Bakken Shale on Oil Drum with some graphs that illustrated your point.


    Another example is the Barnett Shale. Production peaked in Aug ’07 at 84.7 BCF and by March ’08 had fallen to 62.7 BCF, a whopping 26% decline in six months.

    Drilling these sorry reservoirs has historically been a promoter’s dream and an investor’s nightmare. However, with the huge increases in the price of gas, the investors might get bailed out this time.

  4. Anonymous

    The oil company executives, testifying before the congressional sub-commitee, were unanimous in their asertion that the oil market is “well supplied”.

    They also stated that the refineries were not producing gasoline at peak because the market was well supplied.

    At the same time we have Calpers, the British Postal Pension fund, and a host of huge pension funds, SWF, hedge funds, mercantilist national dollar piggy banks, insurance companies, and our own Fed funded investment banks putting money to work in the commodity markets.

    Traders would like us to believe in peak oil, declining resources, and other diversionary rhetoric. They ain’t making any more land (to iteratate their siren call during the housing bubble).

    Which is the most logical scenario ? That demand suddenly exceeded supply, even though demand has dropped significantly ? Or that the highly leveraged, unregulated futures whorehouse is driving the price into a bubble in front of a wave of speculative cash ?

    Hamilton has never met a price action that he hasn’t attributed to “free competitive market” pricing. He has yet to recognize a bubble/swindle while it was occurring or to acknowledge the numerous market swindles that have been exposed over the years. I think he was espousing a cometitive market scenario during the 2004 natural gas swindle.

  5. Juan

    Given the weight placed on NICs, I would have thought price subsidies might have been mentioned, but I would also have thought JH might consider the volatility changes indicated in Figure 2 to be associated with three distinct price regimes.

  6. another anonymous


    I don’t buy your assertion that the earthquake in China will lead to more diesel use on anything more than a short-term basis, as in during the rescue phase.

    Michael Pettis:

    Sichuan is 4% of GDP, main impact will be to increase ag costs since it is a pig producing area

    China is believed to be about to relax price controls on oil due to earthquake. Now would be a good time to ask for sacrifices. That will lower demand once it works through.

    Fuel is being diverted to the rescue area but supplies are being cut back to other areas (Hunan, Hubei, Guangdong)




    Seven major expressways damaged and tunnels and bridges on five national highways were destroyed. Rescue workers having trouble getting into area. That implies once the rescue push is past, less rather than more car/truck activity in the area.

    Government agencies asked to cut spending to fund rescue effort. China is trying not to have undue fiscal stimulus.



    In general:

    10 million people who had a reasonable life are now living in tents or worse. I doubt their diesel use is up. Once the rescue push is past, the ongoing demand from the area will be lower (people who have lost everything they have aren’t going to be using as much fuel as before).

  7. Anonymous

    This doesn’t read as if it is well known that the London oil market have a great deal of oil out of the Middle East tied up at around $3 at the well head. Speculation doesn’t even describe what is going on here.

  8. Yves Smith

    Anon of 11:34 PM,

    Can you elaborate? Thanks. That would explain what the oil execs are saying, but I haven’t seen anyone produce the smoking gun.

  9. Juan

    Pardon the disjointed nature of the following.

    – Without rereading, I’m not sure but believe that JH is relying on official data which, to my understanding, depends on such measures as implied demand, so also official or ‘visible inventories’ that may not be so accurate as imagined. Not yet clear in my mind but am thinking the obscure nature of OTC markets and non-reported inventories are part of the picture.

    Aside from that, and even though he admits the tenuous quality, I’ve a sense the paper is another example of a dominant theory finding that which it has presupossed.

    – Anon 11:34, Isn’t it correct that ‘the London oil market’ is the ICE, which acquired the IPE in 2001 and is a global electronic trading platform advantaged, perhaps, by its slightly earlier launch partners as well as JCS’s foresight?

    – Yves, I don’t believe there is a ‘smoking gun’ but a process which has been compounding since, if I can rely on Citi’s Alan Heap, at least early 2004 when reallocating activities of long only funds had become noticeable.

    While long, you might be interested in Frank Veneroso’s 17 April, 2007, World Bank presentation:

    Reserve Management
    The Commodity Bubble, The Metals Manipulation, The Contagion Risk To Gold And The Threat Of The Great Hedge Fund Unwind To Spread Product


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